My opinions on value investing. The idea is to create a value discussion on stocks and concepts. You might find this blog leaning a bit towards Dalal Street but the concepts should travel well across global markets.
Please note that I may or may not have a position in these stocks. Please use these opinions after through independent research and at your own risk.

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Wednesday, April 22, 2015

Valuation of the ability to command prices: The brand

“Your
premium brand had better be delivering something special, or it's not going to
get the business.”

Warren
Buffett

Willingness to pay for a brand is something
that has to be measured in the marketplace. If you are looking at something
like Tide from P&G and see a generic washing powder you could see the
reaction of people who may or may not pay up for the brand. Another way to
check this is to compare the margins of the company in question with competition
and with generic manufacturers of the same thing. Ajanta pharma is a generic
branded formulations manufacturer whose margins are more than the non-branded
generic manufacturers.

The value of the brand is not a separate
activity but included in the financials. If you look at businesses such as
Colgate or Hindustan Lever, they have such strong brands that their return on
invested capital (ROIC) is north of 50% and some can argue that Colgate is
north of 100%. Think about that. If they invest a 100 rupees into their
business they get 50 to 100 back just in the first year. And that continues to
happen year after year. They of course cannot continue to invest a significant
portion of their earnings into the business because there isn't that much
market for their products so a majority of what they earn gets paid out as
dividends. For a 100% ROIC business, a 20% growth rate, would mean they pay out
80% of their earnings every year as dividends. This dividend cash flow and the
growth, using the same Fair P/E formula is how this brand should be valued.

On the flip side luxury brands aren't always economically excellent. From a value investing perspective a Hero Honda
or Bajaj Auto is a far superior brand than Daimler AG. The return on capital
for the former 2 companies is north of 40% whereas Daimler AG has an under 10%
return on capital. This is very difficult for automotive enthusiasts to swallow
but it’s true.

Another concept that I find hard to explain
but is also relevant is that margins are important but not as important as
return on invested capital. If a brand has 50% margins but 10% returns on
capital that just means they are overpriced to the point where the capital
turns just don’t justify the existence of the brand.

So to summarize the valuation of the brand
– it is only as good as the return on capital it generates. There is not
special formula to value it, just the same simple old fair P/E formula of
growth, return on invested capital and discount rate.